PROFESSIONAL STAGE APPLICATION EXAMINATION MONDAY 5 DECEMBER 2011 (2 hours)

BUSINESS STRATEGY
This paper consists of THREE written test questions (100 marks). 1. 2. 3. 4. Ensure your candidate details are on the front of your answer booklet. Answer each question in black ball point pen only. Answers to each written test question must begin on a new page and must be clearly numbered. Use both sides of the paper in your answer booklet. The examiner will take account of the way in which answers are presented.

The questions in this paper have been prepared on the assumption that candidates do not have a detailed knowledge of the types of organisation to which they relate. No additional credit will be given to candidates displaying such knowledge.

IMPORTANT Question papers contain confidential information and must NOT be removed from the examination hall. Place your label here. If you do not have a label you MUST enter your candidate number in this box.

DO NOT TURN OVER UNTIL YOU ARE INSTRUCTED TO BEGIN WORK

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1.

KoganAir plc (KoganAir) is a listed, low-cost airline based in the UK. It flies only on shorthaul routes within Europe. Industry background The passenger airline industry consists of two sectors, scheduled and non-scheduled. The scheduled sector operates to a published timetable. It includes long-established airlines (eg, British Airways, Emirates, Lufthansa) operating flights on both short-haul and intercontinental, long-haul routes. It also includes low-cost airlines (eg, easyJet, Ryanair) which operate flights almost exclusively in the short-haul sector. The non-scheduled sector comprises all other air transport which, in respect of passenger transport, consists mainly of charter flights operated exclusively by holiday companies to take their customers to a particular holiday destination. Competition is particularly intense in the European airline industry as many low-cost airlines operate in this geographical region, competing with the established airlines of each country. Historically, the established airlines dominated the industry due to their size, enabling economies of scale. They were also often government-subsidised, national carriers with monopolies over certain routes (ie. rights to operate flights between specified airports) and landing slots (ie. rights for a given period, allocated to an airline by an airport, to schedule landings or departures). However, international deregulation of airlines (sometimes referred to as the open skies policy) has meant lower barriers to entry, which has led to many new entrants to the industry in the past two decades. Reduced government regulation over permitted routes has allowed market forces to increase access to landing slots and to determine mergers between airlines and pricing. Despite deregulation, there is not yet full open access to routes and landing slots, as established airlines have retained some of their historical dominance at key airports. However, newer airlines entering the industry have cost advantages over traditional airlines, for example by setting up lower cost wage agreements. Many of the new entrants have been low-cost airlines which have penetrated the scheduled market by attracting individual customers with low fares, popular routes, frequent flights and ease of booking on-line directly with the airline. In the past 15 years, many of these entrants have become market leaders in terms of short-haul passenger numbers. The airline market has experienced long-term growth but has, more recently, suffered a decline in revenues and passenger numbers as a result of the global economic downturn. In addition, airline profits have been affected by high and volatile fuel prices, which comprise a high proportion of total costs. Other concerns facing the industry are: security issues, regulatory intervention, specific taxes on airlines, industrial action and ecological issues.

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Company history KoganAir was established in 1996 and immediately acquired aircraft, along with the rights to landing slots and routes, from the liquidator of an insolvent airline. The fleet has since been expanded by both purchasing and leasing aircraft in approximately equal numbers. As a low-cost airline, KoganAir quickly penetrated the scheduled market and has significantly increased its total number of passengers each year. In order to offer low fares, KoganAir aims to operate at the lowest possible cost in its sector of the industry. It operates a no frills service to passengers (eg, no free food, drinks or films during flights) and it also constantly seeks to minimise the turnaround time spent by its aircraft at airports in order to maximise utilisation. KoganAir has continued to expand but the November 2011 management accounts, released internally last week, make clear that profits for the year ending 31 December 2011 will be significantly lower than last year. This decrease has been expected and profit warnings were given to financial markets in October 2011. However, since then, analysts have made increasing demands for more details, including information about how much of the fall in profit is due to industry-wide factors, and how much due to company-specific factors. A meeting of executive management was called to evaluate the issue in more detail and to determine an appropriate strategy for moving forward. Executive management meeting The chief executive summarised the situation: In many ways we have been successful but, despite increasing revenues in 2011, we have suffered a significant decrease in profits and I do not believe we have adequately analysed the underlying reasons for this. Fuel costs increased, on average, by 17% per tonne in 2011 compared with 2010, driven by the world price of oil, but fuel costs are only one factor. I need an analysis of our basic financial and operating data (Exhibit 1) to explain in more detail why profits have fallen. I am also worried about the impact of further increases in global oil prices next year, as I fear these could cause our fuel costs to rise by as much as 30% per tonne. I have provided some key working assumptions for 2012 (Exhibit 2) to enable some scenario planning to be carried out. The aim is to better evaluate our risks and improve our forecasts for 2012. The marketing director had a different issue: I know costs are important, but we need to consider our long-term positioning in the market. We entered the market in 1996 as a lowcost airline and, until recently, this approach has served us well, enabling us to penetrate the market and expand market share. Now, I think we need to reconsider our market positioning and pricing policies. Our margins are just too low to cover even modest cost increases. My proposal is to move to a mid-market position, sitting between the low-cost airlines and the higher priced, long-established airlines. My view is that we should increase passenger seat prices by, on average, 10% next year.

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Requirements (a) As an external adviser, prepare a report to the board which: (i) analyses the data in Exhibit 1 and the other information provided to explain, with supporting calculations, why the operating profit in 2010 is expected to turn into an operating loss in 2011, despite an increase in revenue generated; and (15 marks) (ii) calculates the forecast operating profit for 2012 using the working assumptions in Exhibit 2. In addition, comment on the working assumptions and on the sensitivity of operating profit to fuel cost changes during 2012. (For this purpose ignore the (9 marks) suggestions of the marketing director.) (b) Explain the key risks for KoganAir that arise from factors within the economic, ecological and legal sections of the PESTEL framework. For each risk identified, explain how it might be managed by KoganAir. (For this purpose ignore the suggestions of the marketing director.) (10 marks) Evaluate the suggestion of the marketing director, referring to Porters generic strategies and any other appropriate strategic models. (9 marks) (43 marks) Exhibit 1 Financial and operating data Note 2010 Actual 313 (76) (25) (211) 1 6.4 5.4 84.4% 49 62 7,271 2011* 2012** Estimated Forecast 337 (96) (26) (227) (12) 7.0 6.0 85.7% 50 64 7,868 7.7 6.7 87.0% 53 66 8,500 % change 2010 to 2011 +7.7% +26.3% +4.0% +7.6%

(c)

Total revenue (m) Fuel costs (m) Operating costs of aircraft fleet (m) Other costs (m) Operating profit/(loss) (m) Available passenger seats (millions) Actual passenger seats sold (millions) Load factor % Number of aircraft Routes operated Available seat kilometres (ASK) (millions) * **

(1) (2)

(3) (4) (5)

(6)

The estimates for 2011 have a high degree of certainty as there are only a few weeks remaining in the financial year. Forecasts for 2012 use the working assumptions in Exhibit 2.

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Notes (1) (2) (3) Seat prices increased on average by 2% in 2011 compared with 2010. Comprises: (i) leasing costs and (ii) depreciation of owned aircraft. Available passenger seats are the total number of seats available for passengers to occupy on all flights in the year (across all routes and based on the total number of aircraft in operation). Actual passenger seats sold are the total number of passenger journeys (ie. seats occupied) actually flown in the year. Number of actual passenger seats sold as a percentage of available passenger seats (ie. (4) as a % of (3)). Available seat kilometres (ASK) is the number of available passenger seats, multiplied by the average kilometres per flight.

(4) (5) (6)

Exhibit 2 Key working assumptions for 2012 In 2012, compared with 2011, the following are assumed: The cost of fuel per tonne will increase by 30% The average price per passenger seat will remain constant The amount of fuel used and revenue will vary approximately according to ASK The operating costs of the aircraft fleet will remain constant Other costs will increase by 3%

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2.

Universal Office Supplies plc (UOS) manufactures office equipment for businesses and the public sector. Products UOS manufactures two product lines: communication systems hardware (including videoconferencing, audio conferencing and data sharing equipment) and office furniture (including desks, chairs and storage cabinets). UOS began manufacturing office furniture in 1990 as Office Supplies Ltd and added the communications systems hardware operation in 1995 on acquiring Universal Systems Ltd. After merging, the company became UOS and obtained a listing in 1997, setting up a single factory where each product line is manufactured in a separate section and operated independently. The product lines use very different methods of manufacturing. UOS has many clients who are customers for both product lines. The communications systems hardware section aims to offer its customers the latest technology. Its products are differentiated from those of rivals by the nature and quality of the features provided. Jim Snape, head of communications systems manufacturing, is constantly changing the design and range of the products being offered in order to compete effectively in the market. New clients are frequently attracted to UOS by this product line, although existing clients are also lost to rivals on a regular basis. Prices are above the average for the sector. The head of office furniture manufacturing is Pauline Parks. Office furniture is a mature industry so Pauline has tended to make few changes to manufacturing methods or to the nature of the final products. UOS produces mid-market office furniture and competes on price and service. Current structure UOS has three main operating divisions which are currently vertically integrated, being Procurement, Manufacturing and Marketing. There are also three support divisions: Research and Development (R&D), Finance and Human Resources. By far the largest division is the Manufacturing Division, and the divisional head is Chen Li. This division has responsibility for manufacturing both product lines. UOS attempts to maintain the autonomy of the operating divisions in its use of transfer pricing and by treating each operating division as a profit centre. Inter-divisional transfer prices The Procurement Division sources materials and parts according to the specifications provided by the Manufacturing Division. These materials and parts are sold by the Procurement Division to the Manufacturing Division at budgeted prices agreed between divisional heads at the beginning of the year. These prices include the budgeted direct cost of purchase, plus an allocation (based upon the value of the order) of the budgeted overheads of the Procurement Division. Any purchase discounts achieved by the Procurement Division therefore add to its divisional profit.

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About 95% of the Manufacturing Divisions output is sold to the Marketing Division at negotiated transfer prices which approximate to wholesale market prices. The remaining 5% of the output of the Manufacturing Division, consisting of both product lines, is sold directly to central government under a long-term contract. These items are not dealt with by the Marketing Division at all, but the prices in the government contract are used as a guide for the negotiated prices of all other transfers between the Manufacturing and Marketing Divisions. The Marketing Division sells products to customers at the highest price it can obtain and also aims to sell, for both product lines, additional services such as installation and extended warranties. In recent years, however, the Marketing Division has struggled to break even. The objectives of the R&D Division are product innovation and also cost reduction through improved efficiency. It is autonomous, initiating research projects that it believes will improve processes and products for communications systems hardware. Once a successful R&D project is completed, Jim Snape and Chen Li are informed and implementation of the development work is discussed. No charge is made by the R&D Division to the Manufacturing Division. No work is undertaken by the R&D Division in respect of the office furniture product line. Proposed restructuring The chief executive of UOS, Anna Tudor, wants to restructure the company after Chen Li retires next month. She proposes that, in future, divisionalisation should be on a product line basis, with two operational divisions - Communications and Furniture. Each division would have its own manufacturing, procurement and marketing sections. For operational reasons the R&D Division would remain a separate cost centre and recharge its full costs, including overheads, to the Communications Division, which would initiate all R&D projects. The details, including costings, would be agreed between the two divisions before each R&D project commences. The Human Resources and Finance Divisions would continue to operate as previously. As part of the restructuring, Anna Tudor proposes changes in key positions which include the following: Current structure Chen Li Andy Worrell Pauline Parks Jim Snape Head of Manufacturing Division Head of Marketing Division Head of office furniture manufacturing Head of communications systems hardware manufacturing Proposed structure Retired Head of Communications Division Head of Furniture Division Deputy head of Communications Division

Anna explained these changes to a fellow director. The communications systems hardware section has been underperforming and I largely blame Jim. He is a good engineer, but not a good manager. The focus has been too much on the technological features of the products and not enough on the needs of customers. I want to appoint Andy as head of the new Communications Division to address this problem. We need more of a market focus.

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Requirements (a) In respect of the R&D function: (i) explain how it can contribute to the business strategy of UOS; and (6 marks) (ii) compare and evaluate the current and the proposed structuring and recharging arrangements. (7 marks) (b) Comment on the merits and problems of the companys current divisional structure in respect of the three operating divisions. Include an evaluation of performance measurement and transfer pricing arrangements. (12 marks) Evaluate the proposed restructuring of the three operating divisions. In so doing, suggest and justify the most appropriate method of divisional performance measurement under the proposed new structure. (8 marks) (33 marks)

(c)

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3.

The Conchester Theatre (CT) is a regional theatre, located 250 miles from London. It has a good artistic reputation and is operated on a not-for-profit basis. History and background CT was established in 1948 with a mission: To promote, in the local community around Conchester, traditional plays and musicals with high artistic merit. CT aims to break even financially. Plays are often the work of local playwrights, both current and those who lived in the region in previous centuries. Musicals are traditional and classical, as the theatre has avoided populist musicals in order to remain close to CTs mission. Each production of an individual play or musical normally has between one and seven performances. Membership and demand The theatre building is owned by the local government and leased to CT at a favourable rent of about half the full commercial rental. The theatre holds 800 people and is available for productions five days a week, 50 weeks a year, but it is not normally filled to capacity. It tries to stage many small productions (eg, with local drama groups, colleges and schools) in order to keep the theatre in use even when utilisation is well below capacity. The local population, living within 20 miles of the theatre, is approximately 200,000 people. CT has 1,500 Members who each make an annual donation of 30. The membership is restricted to 1,500 and there is a long waiting list. The Members elect the board of Trustees which runs CT. If CT has any debts it cannot pay, the individual Trustees are potentially personally liable. CT also has a mailing list of Friends of the Conchester Theatre (Friends) who receive information on the latest productions, but they do not need to make any donations. CT maintains a database of Friends with their details (address, age, profession, productions attended) so it can target mailings to those most likely to be interested in certain productions. There are about 4,000 people (including all Members) on this database. Financing The main source of revenue has always been sales of tickets, but ticket sales alone have never been sufficient to cover costs. Tickets all sell for 15 and there are currently no discounts available. Seats are sold to the public on a first come, first served basis. However, Members are offered the opportunity to purchase up to four tickets for each production, one week before the general public. As a result, for popular performances, the Members sometimes take up the entire 800 seats available. The other main source of revenue has been a government grant from the Arts Council. Following reductions in public spending by central government, in 2012 the grant will only be half its previous level, and will disappear altogether in 2013. A basic revenue summary is provided (Exhibit).

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A dispute The board of Trustees has met to discuss ways in which more revenue can be raised to compensate for the loss of the government grant. The chairman started the meeting: We have had an offer of 125,000 in 2012 and 250,000 a year thereafter from a local businessman, Henry Strong. This would replace the government funding that we are losing. There are, however, some conditions attached, including that he sits on the board as a new Trustee. He would also have the right to choose ten productions each year and, as Mr Strong is a keen supporter of populist productions, we do not expect these to be the type of production we would normally put on. I do not like these conditions, but without this money we would start making large losses and we, as Trustees, could be personally liable. I think we should therefore accept Mr Strongs offer. The treasurer of CT objected strongly: Taking up the offer would be contrary to the historic culture of CT and the wishes of Members and other stakeholders. I do, however, recognise that we need to raise more revenue so I suggest we have more flexible pricing. We should stop charging 15 for every ticket and attempt to charge different prices, to different people, for different productions. Requirements (a) (b) Discuss the ethical issues for CTs board of Trustees arising from the offer from Henry Strong. (8 marks) Explain each of the following: (i) the purposes of market segmentation for CT; (ii) how the CT database may be used to segment the market; and (iii) how different prices may be set by CT in order to increase revenue.

(16 marks) (24 marks)

Exhibit Revenue summary Year 2009 2010 2011*

*

Ticket sales 000 1,380 1,440 1,500

Government grant 000 250 250 250

Membership donations 000 45 45 45

2011 data has been reliably estimated given that the year is nearly complete.

It is estimated CT will break even in 2011, but it incurred small operating losses in 2010 and 2009.

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